SPEECHES & TESTIMONY

“Blockchain: A Regulatory Use Case”

May 10, 2016

CFTC Commissioner J. Christopher Giancarlo expands on his “do no harm” regulatory approach to distributed ledger technology innovation by outlining five key steps for regulators to implement to encourage this technology: put our best foot forward, allow “breathing room,” get involved, listen and learn and collaborate globally. Read the full speech below for further details.

Introduction

Good afternoon, ladies and gentlemen. Thank you for your warm welcome.

Before I begin, let me say that my remarks reflect my own views and do not necessarily constitute the views of the Commodity Futures Trading Commission (CFTC), my fellow CFTC commissioners or the CFTC staff.

I have a great deal of respect for the Markit Group, which I remember from my days in the swaps industry in the mid-2000s. Then, it was Markit Partners which provided daily credit default swaps (CDS) pricing that brought needed price transparency to the CDS market.

Markit is also known for hosting some of the most thought provoking conferences in the swaps industry. I have been to this conference in the past, sitting where you are today. I have heard many interesting presentations and speeches, including by the former Chairman of my own agency six years ago at the time of the passage of the Dodd-Frank Act.

So, needless to say, it is exciting for me to be here on this stage at this event as your keynote speaker. I will do my best to hold your attention.

Fortunately, the topic of my address is bigger than that task. The topic is distributed ledger technology, what is sometimes referred to as “DLT” or “blockchain.” In my humble opinion, DLT could be the biggest technological innovation in the financial services industry and financial market regulation in a generation or more.

In fact, I believe there is a link between DLT and the Dodd-Frank Act that was featured in so many presentations at past Markit conferences. The link is that DLT may allow market participants on the one hand to manage the enormous operational, transactional and capital complexities brought about by Dodd-Frank while, on the other, provide regulators with the market visibility necessary to fulfill our mission to oversee heathy financial markets.

The Potential of Distributed Ledger Technology

I have been speaking a lot about DLT recently because I believe in its promising benefits. I also believe that, in order for this technology to flourish, regulators must take a “do no harm” approach. I first addressed the technology in a lecture I gave at Harvard Law School last December.1 This past February the CFTC held a widely attended industry roundtable on blockchain.2 In March I spoke about DLT at the Depository Trust & Clearing Corp.’s (DTCC) Blockchain Symposium3 and addressed it later in Washington at the Cato Institute4 and last week, a few blocks from here, at Consensus 2016.

Today, I want to expand on my “do no harm” approach by outlining five practical steps that regulators must take to encourage DLT innovation. But before I get to those steps I want to briefly tell you why I think DLT is so important and why we regulators need to get it right.

Moving from systems-of-record at the level of a firm to an authoritative system-of-record at the level of a market is a powerful concept.5 Distributed ledgers have the potential to reduce some of the dependence on a trusted third-party, mitigate centralized systemic risk, defend against fraudulent activity and improve data quality and governance.6

DLT is likely to have a broad impact on global financial markets in payments, banking, securities settlement, title recording, cyber security and trade reporting and analysis.7 DLT will likely develop hand-in-hand with new “smart” securities and derivatives that can value themselves in real-time, report themselves to data repositories, automatically calculate and perform margin payments and even terminate themselves in the event of counterparty default.8

DLT may enable market participants to manage the enormous operational, transactional and capital complexities brought about by the legion of disparate mandates, regulations and capital requirements promulgated unceasingly by regulators here and abroad.9 In fact, one study estimates that DLT could eventually allow financial institutions to save as much as $20 billion in infrastructure and operational costs each year.10 Another study reportedly estimates that blockchain could cut trading settlement costs by a third, or $16 billion a year, and cut capital requirements by $120 billion.11

And, while DLT promises enormous benefits to financial services firms, it also promises assistance to financial market regulators in meeting their mission to oversee healthy markets and mitigate financial risk.

To explain this let me take you back for a moment to September 2008. Many of you here today remember those days well. It was indeed a frightening time in global financial markets. An enormous U.S. housing bubble had burst triggering a cascading global credit crisis. Concern was rife about imminent investment and commercial bank failure.

I was then a senior executive of one of the world’s major trading platforms for CDS, said by some to be the epicenter of systemic risk. Panic was in the air and tension was on our broking floor trying to maintain orderly markets. We were in touch then with U.S. bank regulators asking about the CDS trading exposure of several major banks, including Lehman Brothers. In fact, trading conditions were deteriorating by the hour. It was clear that regulators had little means, short of telephone calls, to read all the danger signals that the CDS markets were broadcasting.

What a difference it would have made if regulators had access then to the real-time ledgers of all regulated trading participants, rather than trying to assemble piecemeal data to recreate complex, individual trading portfolios. I believe that, if regulators in 2008 could have viewed a real-time distributed ledger (or a series of aggregated ledgers across asset classes) and, perhaps, been able to utilize modern cognitive computing capabilities, they may have been able to recognize anomalies in market-wide trading activity and diverging counterparty exposures indicating heightened risk of bank failure. Such transparency would not, by itself, have saved Lehman Brothers from bankruptcy, but it certainly would have allowed for far prompter, better-informed, and more calibrated regulatory intervention instead of the disorganized response that unfortunately ensued.

I support the regulatory transparency imperative of Title VII of Dodd-Frank and the earlier G-20 Pittsburgh Accords. I am disappointed that it is not yet realized. That is a big reason why I am so enthusiastic about the promise of DLT. It will give regulators a far better chance than we have today to recognize and respond to systemic risk while there still may be time to do something to mitigate it.

Meanwhile, DLT is moving forward in internet time – or, what we used to call a “New York minute.” Billions of dollars are being invested in dozens of new ventures and innovations.12

Last month, seven firms announced a successful test using DLT and smart contracts to manage post-trade lifecycle events for single name CDS.13 The test, or “proof of concept” (POC), involved a month’s worth of trades roughly equal to $6 trillion in notional value based on an average trade ticket of $5 million. The POC was organized by the DTCC and included Bank of America, Credit Suisse, J.P. Morgan, Citigroup, blockchain technology developer, Axoni, and our hosts today, Markit.14 The POC also demonstrated the potential real-time transparency benefits to regulators.15 I believe that POCs like this one prove there is merit to the promise of potential DLT applications.

Similarly promising projects are underway. DTCC has started working with Digital Asset Holdings to determine whether short-term lending arrangements between dealers known as repos could be settled using blockchain.16 Barclays recently demonstrated a smart contract application for interest rate swaps built on the distributed ledger platform, Corda, developed by R3.17 In the demonstration, a blockchain-based smart contract for an interest rate swap transaction was connected to an ISDA master agreement, the counterparties reviewed the trade, affirmed it and then it was sent to the distributed ledger.18 According to Barclays, this solution “has the potential to transform legal documentation and enable legally-enforceable smart contracts.”19

The “Do No Harm” Regulatory Model

DLT development, such as the projects I just mentioned, is certainly moving rapidly, faster than underlying legal and regulatory frameworks. Rules regarding DLT are currently unwritten and likely years away, leaving the industry with little clarity.20

Investment in DLT faces the danger that, when regulation does come, it will come from a dozen different directions with different restrictions stifling crucial technological development before it reaches fruition. That is why two months ago, I called for the “do no harm” approach similar to the early Internet.21

“Do no harm” was unquestionably the right approach to development of the Internet. Similarly, “do no harm” is the right approach for DLT. Once again, the private sector must lead. Regulators must avoid impeding innovation and investment. Instead, they must provide a predictable, consistent and straightforward legal environment. Protracted regulatory uncertainty or an uncoordinated regulatory approach must be avoided, as should rigid application of existing rules designed for a bygone technological era.22

Several overseas regulators have already taken this common-sense approach. In October 2014, the United Kingdom’s (UK) Financial Conduct Authority (FCA), its primary markets regulator, created an “Innovation Hub” and launched “Project Innovate.”23 Through this initiative, financial technology or “FinTech” and other businesses – both new and established – are able to introduce innovative financial products and services to the market.24 These businesses consult with a dedicated team of technologically sophisticated FCA staff, receive assistance in understanding how regulatory requirements apply to their businesses and benefit from relief from certain rules on a temporary basis.25 The Innovation Hub also works to identify areas where the regulatory framework must adapt to enable further innovation.26

The Innovation Hub will feature a “Regulatory Sandbox” in which businesses will be able to test new ideas with a small set of customers.27 Firms in the sandbox will be able to operate without running afoul of ordinary regulatory requirements.28 Firms will be selected based on potential benefits to customers and market participants, greater competition, increased transparency or reduced cost.29 The FCA and businesses must agree to POC success metrics and wind down plans if unsuccessful.30 This Regulatory Sandbox was scheduled to be launched yesterday.31

Unsurprisingly, the FCA’s Innovation Hub has received a lot of positive attention and some close following. Last week, Australian regulators announced that they would follow the FCA with the launch of their own regulatory sandbox.32 Similarly, authorities in Singapore are likely to establish a regulatory sandbox for FinTech firms before the end of the year.33 The Monetary Authority of Singapore (MAS) is committing massive resources to turn the city-state into a pre-eminent regional FinTech hub.34 For example, the MAS has committed $384 million to assist FinTech startups over the next five years and has created several FinTech offices and labs.35

Japan has also acknowledged the need for a flexible approach to regulation of new technologies. Masamichi Kono, Vice Minister for International Affairs at the Japan Financial Services Agency (FSA), stated that regulators must take a “pragmatic and flexible approach” to regulation of new technologies so not to stifle innovation.36 The FSA has also established a “Panel of Experts on FinTech Start-ups” in order to promote the growth and success of FinTech firms in Japan.37 In addition, Japan’s trade ministry is soliciting public comment on blockchain technology, including its effect on financial services and regulation.38 The trade ministry intends to use the comments in developing a policy proposal on FinTech.39

On this side of the Atlantic, the State of Delaware has actively embraced the “do no harm” approach to DLT. The state recently announced the “Delaware Blockchain Initiative” that “aims to encourage expanded use and development of distributed ledger and smart contract technologies by Delaware-incorporated businesses.”40 At the recent Consensus 2016 blockchain conference, Delaware Governor Jack Markell discussed the initiative, which includes creating a new category of corporate shares called “distributed ledger shares.”41 As part of this process Delaware is discussing any possible tweaks to its corporation law in order to provide regulatory certainty.42 Delaware is also exploring blockchain use-cases for its own purposes, such as registering new companies, recording land records and submitting court filings.43

In my Harvard Law School lecture last December, I said that much of the discussion around global financial markets is backward-focused and that regulators’ agendas must be more forward-looking so that we have a clear view of the challenges and developments ahead.44 The UK, Australia, Singapore, Japan and the State of Delaware are among several jurisdictions that have been looking forward and fostering DLT development through a “do no harm” regulatory approach. I have been advocating for the CFTC to have a forward-looking agenda for some time. This means more than simply codifying already adopted industry best practices with regards to automated trading45 and systems safeguards. Instead, the CFTC and other domestic and overseas financial regulators must come together and look to emulate the UK, Australia, Singapore, Japan and the State of Delaware in order to avoid stifling innovation and DLT’s potential benefits. An international consensus around a “first, do no harm” approach is the right way to avoid impeding essential DLT innovation by protracted rule uncertainty or uncoordinated actions.46

Five Regulatory Steps to “Do No Harm”

Today, I am expanding on my “do no harm” approach by outlining five practical steps that the CFTC and other financial regulators should take to encourage DLT and FinTech innovation. If the CFTC and other financial regulators are serious about a forward-looking agenda then, I believe they should do the following:

1. Put Our Best Foot Forward: Financial regulators should designate dedicated, technology savvy teams to work collaboratively with FinTech companies – both new and established – to address issues of how existing regulatory frameworks apply to new, digital products, services and business models derived from innovative technologies, including DLT;

2. Allow “Breathing Room”: Financial regulators should foster a regulatory environment that spurs innovation similar to the FCA’s sandbox, where FinTech businesses, working collaboratively with regulators, have appropriate “space to breath” to develop and test innovative solutions without fear of enforcement action and regulatory fines;

3. Get Involved: Financial regulators should participate directly in FinTech POCs to advance regulatory understanding of technological innovation and determine how new innovations may help regulators do their jobs more efficiently and effectively;47

4. Listen and Learn: Financial regulators should work closely with FinTech innovators to determine how rules and regulations should be adapted to enable 21st century technologies and business models; and

5. Collaborate Globally: Financial regulators should provide a dedicated team to help FinTech firms navigate through the various state, federal and foreign regulators and regimes across domestic and international jurisdictions.

On this last step, I would like to emphasize that financial regulators must address how to prevent death from a thousand cuts by numerous state, federal and foreign regulators for FinTech firms that look to provide services across various financial market regulatory jurisdictions. Because emerging technology, such as DLT, has the potential to provide many benefits that transcend regulatory boundaries, financial regulations must be harmonized across jurisdictions in order to avoid stifling innovation.

I believe it is indeed time for the CFTC and other financial market regulators to take these affirmative steps to further FinTech innovation and development for the betterment of U.S. and foreign markets and market participants.

Foster Job Creation

Earlier in my address, I laid out two reasons why we need DLT to succeed.

Reason number one is so that the financial services industry can better meet its obligations of financial market reform and regulation.

Reason number two is so that financial regulators can fulfill their mission to minimize systemic risk through far better visibility into market health and resiliency – visibility that remains incomplete today.

Reason number three is simpler than the first two: it is American jobs.

As I noted in my Harvard lecture, the blockchain revolution will not come without some adverse consequences, including a possible sharp reduction in the human capital that supports the recordkeeping and transaction processing of contemporary financial markets.48

When I first started out as a young lawyer in 1984 here in New York, I walked each morning west to east across the financial district on my way to work at the foot of Maiden Lane near the South Street Seaport. I saw crowds of workers disembark the Path Train, the Lexington Avenue Subway and the Staten Island Ferry. Some workers were brokers and traders heading for the floors of the New York and American Stock Exchanges and the New York Mercantile Exchange. Many others were middle and back office staff heading to countless offices to record, confirm and reconcile those floor trades.

Today, those front-office floor trader jobs are mostly gone, replaced with automation and algorithms. Tomorrow, sadly, many of those middle and back office jobs may also be gone, replaced by automated smart contracts and DLT.

A recent report by Citigroup forecasts that retail banking automation including blockchain could spur a 30 percent decline in banking jobs across the U.S. and Europe over the next decade, the equivalent of eliminating nearly two million jobs.49 For New York, it will be the end of another era in the evolution of its trading markets and the working life of this great city.

It is no wonder then that other world trading centers – like London and Singapore – faced with the loss of financial service jobs, are taking affirmative steps to attract a new generation of FinTech start-up companies and welcome the jobs they create.

Last month, a senior representative of Her Majesty’s Treasury announced that the UK will establish an “industry-led panel” that will set an overarching strategy for the British FinTech industry.50 She went on to say, “[t]he [UK] government wants to ensure the UK continues to be the best place in the world to be a FinTech company.”51

And let me tell you, she is not kidding. Investment in the British FinTech sector already exceeds that of New York.52

It is time to hear similarly strong voices on this side of the Atlantic. U.S. lawmakers concerned about the rapid loss of jobs in the U.S. financial services industry, especially in the New York City area where job losses are pronounced,53 should similarly roll out the welcome mat to U.S. FinTech and DLT innovation and entrepreneurship and the well-paying jobs that will surely follow.

I hope policymakers will support the proposals I have made today. American global leadership in the technological innovation of the Internet was built hand-in-hand with regulators’ enlightened “do no harm” approach. The same opportunity for technology leadership is present today – if policymakers have the good sense to seize it.

Conclusion

In drawing to a close, I believe that by following the steps I have proposed today to encourage the development and application of DLT and other digital technology, regulators and policymakers will best seize the opportunity to realize three essential goals:

3. Foster a new generation of FinTech businesses and services and welcome the American jobs they create.

Let us work together to take the practical steps I have outlined to further FinTech and DLT innovation and development for the health and betterment of U.S. financial and capital markets, market participants and the American jobs that they support.